September 24, 2008

The Treasury Bailout is not rocket science

The debate over the proposed Treasury bailout of Wall Street firms is coming at a fortuitous time -- the election season. Be wary of any candidates who, after looking appropriately concerned about the dire predictions of the plan's promoters, throw up their hands and vote in favor of the bailout because "we just have to do something" even if they don't understand what they are doing.

The fear mongering that the promoters are using to sell the bailout is laughable. This is not rocket science.

For example, when Enron tanked in late 2001, it was the seventh largest public company in the U.S. Enron traded derivatives and other financial instruments with counterparties that were among Wall Street's biggest commercial and investment banks, which were heavily exposed to its losses. To make matters worse, these investments were concentrated in the energy sector, which is at least as important to the nation's economy as the housing sector that is at the center of the current crisis.

In short, at the time of its bankruptcy, Enron was one of the nation's largest publicly-owned companies, a vitally-important market-maker in the natural gas trading industry and a leader in hedging corporate risk through structured finance transactions.

Despite the huge wealth destruction that would result from Enron's insolvency, not one government or Wall Street leader proposed a bailout of Enron in order to preserve the huge value to the public of the natural gas trading industry and the market for structured finance transactions.

Enron's bankruptcy proceeded to cause enormous tremors through various industries -- particularly the energy industry -- because valuable resources for hedging risk of loss had evaporated seemingly overnight. The natural gas trading industry nearly fell apart completely, costing companies and their customers untold billions of dollars that they otherwise could have saved through hedging risk of loss. Similarly, the market for many structured finance transactions dried up, also costing companies another valuable avenue for hedging risk.

However, the nation's financial system did not break down. Companies adjusted to the changed circumstances and endured their additional costs as best they could. Markets also adjusted. Slowly but surely, both the natural gas trading industry and the market for structured finance transactions rebounded so that both are again providing companies with valuable alternatives for hedging risk and saving money.

Now, the tables are turned on Wall Street. Rather than facing the consequences of their risk-taking decisions in chapter 11, Wall Street's politically well-connected leaders are weaving their tales of doom for the overall economy to compliant governmental leaders who are only too willing to do their bidding.

In reality, each of these Wall Street firms should be required to endure the same thing that Enron and its creditors did -- a chapter 11 reorganization where equity gets wiped out and creditors either take a haircut on payment of their debts or convert their debt to equity in a reorganized firm that emerges from bankruptcy with a cleaned-up balance sheet.

That process ensures that investors and creditors who undertook the risk of investing or dealing with the bankrupt firms share the losses of their risk-taking. Moreover, it allows the firms that really are worth saving (as opposed to simply liquidating) to emerge from bankruptcy with an improved financial condition that should provide the firm with an enhanced opportunity to create wealth again.

What the bailout plan proposes to do is insulate investors and creditors from risk of loss by having the government -- funded by taxpayers such as you and me -- undertake that risk. There is simply no moral justification for foisting that risk on taxpayers and the only possible practical justification is that sorting all of these firms' problems out in chapter 11 might take awhile.

But even if the government saw fit to accelerate the Wall Street reorganizations to hedge the risk of a prolonged economic downturn, there is simply no reason for the government to overpay for assets from financially-troubled firms. Rather, the government should simply propose a plan that implements the going-concern liquidation and debt-for-equity reorganization features of chapter 11 on an accelerated basis in return for some reasonable financial contribution to the process. And you can bet that contribution doesn't need to be close to $700 billion.

Luigi Zingales, the Robert C. Mc Cormack Professor of Entrepreneurship and Finance at the University of Chicago, has written the most cogent piece I've seen to date on why the bailout is a bad idea. Even though it was wrong for the government to contribute to the massive amounts of wealth destruction that resulted from the demonization of Enron, the government was right not to bail out Enron. The circumstances are different now, so perhaps a different approach is more prudent than simply allowing all of these Wall Street companies to be sorted out in chapter 11.

But throwing $700 billion at investors and creditors who should be sharing the losses of their risk-taking is not even close to the best way of doing it.

Update: I couldn't help but laugh out loud this morning as Warren Buffett and the promoters of the Treasury bailout plan point to Buffett's sweet $5 billion investment in Goldman Sachs as an endorsement of the plan.

I prefer to look at what Buffett is doing rather than what he is saying.

What he is not doing is what Paulson and Bernanke want the U.S. Treasury to do -- buy investment banks' toxic assets. Rather, Buffett is buying preferred shares in Goldman with a big yield and warrants to buy Goldman stock at $115 (its trading at over $130) so that he can recover the profit his investment helps foster while Goldman transitions from an investment bank to a bank holding company over the next couple of years.

Meanwhile, Paulson and Bernanke keep promoting their plan to throw $700 billion at whatever trashy assets that Wall Street serves up to them.

It does not engender much confidence that Buffett can cut a far better deal with Wall Street's best-run investment bank than Paulson and Bernanke propose to cut with the worst-run ones.

Posted by Tom at September 24, 2008 12:01 AM |

Comments

Yep -- and in the late 1980's living in Houston I wrote a check to sell our house whose value had collapsed from the inflated prices of the early 1980's when Houston's economy was overheated. Nobody bailed us out then, and life went on . . .

A root issue underlying all of this "rocket science" is that a house is an asset that can fluctuate in value just like a stock or bond. But because the government does not treat housing this way (tell me again the logic of the mortgage interest deduction, etc . . . ?) nor necessarily encourage home buyers and owners to think of it this way, we end of with a blow up with a bunch of people having their hands out. And unlike Enron stakeholders or real estate owners in Houston in the 1980's, they'll get us all to pay for their bad decisions because they have the political means to do so . . .

Posted by: Steve at September 24, 2008 9:14 AM

Tom:

This whole issue is an emotional one. The questions are simple. What happens if we don't do something? How much will it really cost the tax payer if we spend the money? Who will benefit if we proceed with the bail out? There is way too much politicking going on from all sides.

Well said Tom. The Fed is not the government--it is private banks now holding assets that put its owners and managers in harms way. It has a vested interest in selling these to the taxpayers, represented by Congress, for more than they are worth both to (i) avoid loss, and (ii) create future profit. Paulsen is a banker; and we can see where the administration lines up (and it is not for the taxpayer). If this is not done, then credit will remain harder to get, probably like in the 1980's when real due diligence went into a lender's decision to extend a loan, and the borrower had to put real money down (all of 10-20%) to buy a house. What happens when prices in areas far outpace wage gains when hit by net lost jobs because industry collapses? Sounds like the Southwest (and Houston particularly) in 1984-1988. We survived; it was hard; yet many benefitted because they could afford a house.

Does the large amount of debt to China matter? Or is this a factor in other Govt take-overs (Freddie Mac and Fammie Mae)?

Posted by: GRG51 at September 24, 2008 1:28 PM

Gary, I would contend that the amount of debt held by China is largely irrelevant to these issues. Frankly, that China is electing to hold large amounts of US debt securities reflects the security of US debt in comparison to alternative investments.